Question

Presented below are the comparative income and retained earnings statements for Martinez Inc. for the years 2017 and 2018.

		2018			2017
Sales		$334,000			$264,000
Cost of sales		217,000			144,000
Gross profit		117,000			120,000
Expenses		95,200			50,700
Net income		$21,800			$69,300
Retained earnings (Jan. 1)		$121,700			$76,300
Net income		21,800			69,300
Dividends		(31,400	)		(23,900	)
Retained earnings (Dec. 31)		$112,100			$121,700

The following additional information is provided:

1.		In 2018, Martinez Inc. decided to switch its depreciation method from sum-of-the-years’ digits to the straight-line method. The assets were purchased at the beginning of 2017 for $106,500 with an estimated useful life of 4 years and no salvage value. (The 2018 income statement contains depreciation expense of $31,950 on the assets purchased at the beginning of 2017.)
2.		In 2018, the company discovered that the ending inventory for 2017 was overstated by $24,200; ending inventory for 2018 is correctly stated. Prepare the revised retained earnings statement for 2017 and 2018, assuming comparative statements. (Ignore income taxes.) MARTINEZ INC. Retained Earnings Statement For the Year Ended

2017 2018

	2017
RETAINED EARNINGS, JANUARY 1, UNADJUSTED
LESS: CORRECTION OF ERROR FOR INVENTORY OVERSTATEMENT
RETAINED EARNINGS, JANUARY 1, ADJUSTED
ADD: NET INCOME
LESS: DIVIDENDS
RETAINED EARNING, DECEMBER 31

Answer 1

* CORRECT ANSWER

• There are two errors or adjustments mentioned:

First: Methods of depreciation has to be changed from Sum of Digit to Straight Line method, and
Second: Overstatement of Ending Inventory for 2017

• Effect of Change in Method of Depreciation

The depreciation method in 2018 has to be changed to Straight Line Method. But Depreciation expense of $ 31,950 (mentioned in the question) is already recorded in Income Statement under ‘Expenses’.

The above $ 31,950 is calculated using Sum of Digit method as follows:

Life = 4 years: Sum of digit = 1 + 2 + 3 + 4 = 10

Year	Depreciable base	Formula	Depreciation expense	Accumulated Depreciation	Ending Book Value
2017	$     106,500.00	[106500 x 4/10]	$         42,600.00	$       42,600.00	$        63,900.00
2018	$     106,500.00	[106500 x 3/10]	$         31,950.00 [matching with the amount of 2018 depreciation expense]	$       74,550.00	$        31,950.00
2019	$     106,500.00	[106500 x 2/10]	$         21,300.00	$       95,850.00	$        10,650.00
2020	$     106,500.00	[106500 x 1/10]	$         10,650.00	$    106,500.00	$                        -

Now, as you can see, Book Value at the beginning of 2018 or Ending book Value for 2017 (after 2017’s depreciation expense) = $ 63,900.

This $ 63,900 will be depreciated for remaining life of 3 years [4 years – Year 2017 already passed]

If Straight Line method was followed, annual depreciation for 2018 would have been: $ 63,900 / 3 years = $ 21,300

A	Depreciation expenses recorded as per 'sum of digits' method	$            31,950.00
B	Depreciation expense that should have been recorded as per Straight Line Method	$            21,300.00
C = A - B	Excess depreciation recorded	$               10,650.00
D	Net Income for 2018 (when Sum of digit method was used)	$            21,800.00
E = C + D	Updated Net Income for 2018 will be (before taking into account Issue #2 of Inventory)	$            32,450.00

• Effect of Overcasting of Ending Inventory of 2017

This error has two main effects:
>Effect 1: Since Ending inventory of 2017 is overcasted, Cost of Sales would have been undercasted, leading to Higher Gross profits and Higher Net Income, ultimately leading to Higher Retained Earnings.

>Effect 2: Ending Inventory of 2017 becomes Beginning inventory for 2018. Now Beginning Inventory of 2018 is Overstated. This has lead to overstatement of Cost of Sales, leading to lower gross profits and lower net income, ultimately leading to Lower retained earnings.

Note:

---Updated Net Income for 2018 after Straight Line Depreciation = $ 32,450 (calculated above)
---Adjustment of overcasting of Beginning Inventory = $ 24,200
---Correct Net Income for 2018 = $ 32,450 + $ 24,200 = $ 56,650 (to be used in answer)

• Answer, as required

MARTINEZ INC.
Retained Earnings Statement
For the Year Ended
	2018	2017
RETAINED EARNINGS, JANUARY 1, UNADJUSTED [given]	$          121,700.00	$                  76,300.00
LESS: CORRECTION OF ERROR FOR INVENTORY OVERSTATEMENT	$            24,200.00	$                  24,200.00
RETAINED EARNINGS, JANUARY 1, ADJUSTED	$            97,500.00	$                  52,100.00
ADD: NET INCOME	$            56,650.00 [updated as calculated above]	$                  69,300.00
LESS: DIVIDENDS	$            31,400.00	$                  23,900.00
RETAINED EARNING, DECEMBER 31	$          122,750.00	$                  97,500.00